Is Inflation Risk Likely to Increase? – A Low-Cost Option Strategy for Possible Participation

Bamberg, Germany

As long-time ITA members may recall I have often considered taking GLD (Gold) out of my investment “quivers”. The reasons for doing this would be because back-testing has shown that it’s inclusion has not really contributed to portfolio performance over the past ~13 years (pre 2008 recession). Also, GLD does not offer any “compensation”, in the form of dividends, for holding.

But Gold has, historically, acted as a “safe haven” in times of uncertainty and, particularly, inflation. Originally, we, at ITA Wealth, included Inflation-protected bonds (e.g. TIP) in our investment quivers – but, over the past few years, we have tended to remove this asset class from these quivers due to the low inflation rates seen worldwide. However, with the Fed, and other Central Banks, currently lowering interest rates and otherwise trying to encourage spending, in response to the current Covid-19 pandemic and in an effort to keep the economy running it seems that this might lead to higher inflation in the future. If this should occur, then a position in Gold may not be a bad investment.

Since higher inflation and an increase in the price of Gold is by no means a certainty, how then might we position ourselves to benefit from such a move should it occur whilst still being conservative enough to protect ourselves if gold goes nowhere or even declines slightly. The answer might be to take a position in GLD through the use of Options. I recognize that most ITA members have no interest in Options – so those members can save time and stop reading this post here – however, for those with even a minor interest, here’s an idea.

With volatility currently at high levels Options are expensive to buy – so Options traders prefer to take advantage of this high volatility by selling premium rather than buying it. Bearing this in mind, let’s take a look at how we might construct a strategy to satisfy our requirements.

First, we’ll consider the purchase of a deep In-The-Money (ITM) Call option with an expiration date ~12 months from now. Let’s say the $120 strike Call expiring 19 March 2021:

This Call Option can be purchased for $38.35, or $3,835 for one contract and gives us the option (but not the obligation) to buy 100 shares of GLD at $120 at any time before expiry next March.

With GLD currently trading at $152.95 this Option is $32.95 ITM (152.95-120) – or, in “Options speak”, has $32.95 of intrinsic value. The difference between the purchase price of the Option ($38.35) and the intrinsic value ($32.95) – $5.40 or $540 per contract – is the extrinsic value contained in the Option price or, put another way, the premium that we pay for owning this Option and the right to acquire shares at $120.

The first thing we want to do is to recover this ($540) premium and we’ll look at ways to do this in a moment. But first, let’s look at the Profit/Loss graph shown above to see how much risk we have in this position. As we can see, our risk is limited to the price we pay for the Option – or $3,835 in our example.

Since the Cost of buying 100 shares of GLD would be $15,295 (with GLD at $152.95 per share) this represents a maximum loss of 25% on such a purchase – not great, but at least limited – although it is difficult to think of a scenario where Gold might go to zero. We’ll be coming back to how we might reduce this risk later.

First, let’s take a look at how we might recover the $540 premium paid for the Option. The most obvious way to do this is to sell Option premium against the long Call Option that we are holding. Due to the way Options are priced, premium decay is highest in the 30 days before Options expiration. So, let’s consider selling an Option that is expiring ~1 month from now – the April 17, 2020 Options – and, specifically the $159 Strike contract:

As we can see, we can sell the $159 Call Option expiring on April 17, 2020 for $2.35 (or $235 for 1 contract). This covers ~40% of the extrinsic cost of the longer term contract that we have bought. So, we can see that, if we can sell similar premium in subsequent months, when the shorter-term Options expire, we can quickly recoup (in 2-3 months) the cost of buying the longer term ($120 Strike) Option. At the same time, each time we sell premium we will reduce our risk. So, assuming we can sell Options at a similar price over the next 3 months we will have paid for the extrinsic cost of our long position and reduced our risk by ~$700 (3 x $2.35 x 100) to $3,135 (~20% of risk if holding 100 shares of GLD).

Beyond this, we may have the opportunity to keep selling Options for another 9 months (until the expiration of the long Option) with the possibility of generating an additional $2,100 that would reduce our risk to ~$1,000 or ~$6.5%. If the price of GLD were not to change over the next 12 months (not a realistic expectation) then this $2,100 could be thought of as “dividend” income – a ~55% return on our $3,835 investment!

Of course, the price of GLD will not stand still for 12 months and adjustments will need to be made along the way. There are (at least) 3 things that might be done:

1. If prices move up we can “roll up” the long Call contracts. For example, if GLD were to move up ~$5 to ~$158 we might roll up the long $120 Calls to the $125 Strike price. This would immediately reduce our risk on the position by $500 and we might bring in an additional credit of ~$400 (depending on how long it might take to make this move).
2. Of course, if price moves up we might also have to adjust our short Options contracts since they will be restricting potential profits beyond the Strike price of the short Calls ($159 on the initial position). This adjustment will likely be to roll the short Option “Up and Out” i.e. up in Strike price and out in time.
3. If prices move down we might consider buying back the short-term Option we have sold and selling a lower strike Option.

Obviously this strategy requires attention and will seem complicated to those not familiar with Options. I have only outlined details for how the position might be managed but, for those that might be interested to follow this strategy for a few months, I will try to put on a position on Monday and will post subsequent adjustments as required beyond that.

[Note: the shaded area in the above figures represents a plus or minus 1 Standard Deviation move in GLD to the nearest expiration date i.e. to March 2021 in the first figure and to April 2020 in the second figure. The probability of price closing within these ranges within the respective time periods is ~68%.]

Update: 30 March, 2020:

This morning I was filled on this position at a net cost of $3,500. The trade was placed as a single order “diagonal” trade because this generally results in better pricing – especially when bid/ask spreads are wide due to low liquidity – that tends to be the case for options not expiring for ~1 year. The trade looks like this:

and the breakdown of prices is that the long Call was purchased for $37.18 ($3,718) and the short Call was sold for $2.18 ($218). This is shown in the following screenshot of a spreadsheet page that I will be using to track/monitor this position:

GLD was trading at $152.85 at the time.

The extrinsic value (premium) in the long Call that was bought is $433 (100 x ($37.18 – ($152.85 – $120))) and this is the first cost that we need to recover. Picking up $218 for the first Call sold gets us half way there.

Update: 3 April, 2020:

Although GLD made a mild pullback in prices this week it managed to end the week relatively unchanged at $152.65 – down only $20 on a 100 share holding.

The option position is showing a $40 loss but this is based on mid bid/ask prices with wide bid/ask spreads – so, practically, about the same as for a direct investment.

I will update again next week – unless an adjustment is necessary. I was watching as prices dropped and considered rolling down the short Call to bring in more credits – but then prices bounced back so no adjustments were made.

Update: 9 April, 2020:

Gold made a significant move higher this week with the price of GLD closing at 158.69. Had we been holding 100 shares of GLD this would have been an increase in value of $584, resulting in a 3.82% increase from our initial purchase price:

Using mid bid/ask prices for the Options that we are holding, the long-term ITM March 120 Call is now trading at $41.20 – or up $402 on one contract. Meanwhile, the short-term April 159 Call that we sold is trading at $1.78 so our “profit” on this portion is $40 – for a net profit on the total position of $442. This represents a Return On Investment (the purchase of the long-term ITM Call), ROI, of 11.89% or a Return On Risk, ROR, of 12.63% after taking into account the credit from the Option sold.

With the short Call now trading at $158.69 and the strike price, where this Option moves ITM, at 159 it is time to consider rolling this Option “up and out” – for example to the 17 April expiration of the $165 strike price. At the close on Thursday this adjustment could have been made for a credit of ~0.77 ($77 on one contract).

At the same time, it is worth considering rolling the long Call up in price (but with the same March 2021 expiration) from $120 to $125 to reduce risk. This adjustment could have been made for a credit of ~4.23 ($423 on one contract). From a technical perspective this results in taking advantage of the fact that the original $120 Call, that had a “delta” value of ~0.85 when purchased, now has a “delta” of ~0.89 – since it has moved further ITM. Selling this out and replacing with the $125 Call that is now trading at the same 0.85 delta as the original Option generates this credit.

If both of these adjustments were made we would bring in a total credit of ~$500 and would reduce our maximum risk by the same amount to $3,000.

Although I seriously considered making these adjustments on Thursday I decided to hold my current positions over the week-end to see where we are when the market re-opens on Monday, after the holiday. This allows for more time decay in the short ($159 strike) Call that expires next Friday. Either way, I am likely to be making an adjustment in the next week and will post the adjustment when made.

Update: 14 April, 2020:

I finally got my account sorted out and have adjusted my positions. Unfortunately I could not adjust as I had intended as price has moved up too far to enable me to generate a credit by selling the May 165 Call. Consequently I had the option of either selling a May 164 Call that is closer to the current price or rolling further out in time to a higher strike. I chose to buy back the April 159 Call and sell the May 164 Call for a small credit of 0.10 ($10). If prices continue upwards I will roll again to the June Options.

Because of the ~$11 move in GLD I also chose to roll the long 2020 March Call from the 120 strike to the 130 strike for an 8.60 credit ($860 on one contract). The current positions now look like this:

With GLD currently priced at $163.60, a 100 share position in GLD would be showing a profit of $1,075 (a 7.03% Return on a $15,285 investment).  On the Option position, risk has been reduced to $2,630 and current profit is $640 or a 17.2% Return on Investment (ROI) and 24.3% Return on Risk (ROR).

Graphically the PnL graph looks like this:

Update: 17 April, 2020:

As noted in a recent comment to this post I have added a short vertical Call spread to this position in an attempt to make up for the fact that I was not able to roll the short April 159 Call Option to the May 165 strike on Monday as I had planned. I sold 5 contracts of the May 165/167 Call spread at 0.43 for a total credit of $215. My total position now looks like this:

and PnL, in tabular format, looks like this:

where a 100 share holding in GLD would be showing a profit of $572 or 3.7% ROI and the Option position is showing a profit of $539 or 14.6% ROI/20.5% ROR.

Update: 24 April, 2020:

No adjustments were made to the position this week and the PnL graph currently looks like this:

With GLD up ~$3.50 on the week the numbers in tabular format look like this:

where we see that holding 100 shares of GLD would be showing an unrealized profit of $978 (6.4% ROI) with the Option position showing $416 profit or 11.2% ROI/15.8% ROR. The sale of the 5 contract Call spread is hurting the position at this point since it is showing a loss of $130.

Update: 1 May, 2020:

The current PnL picture looks like this:

with a “paper” profit of ~$600.

With GLD presently trading at $159.78, a 100 share holding in GLD would be showing a profit of $693 or 4.5% Return on Investment:

The original Option position is showing a profit of $544 or a ROI of 14.6% and a Return on Risk (ROR) after adjustments of 20.7%. On top of this, the vertical spread that I placed is showing a profit of $55 with $785 at risk (6.75% ROR).

In total, current Profit is $599 or 17.5% ROR ($3,415 Risk)

Update: 8 May, 2020:

GLD ended the week trading slightly, but not significantly, higher at $160.77:

This corresponds to a $792 (5.2%) unrealized profit on a 100 share holding of GLD. The profit on our initial Option position is $764 or 20.6% ROI and 29% ROR. Including our side trade, that adds an addition $100, total (unrealized) profit is currently $864 or 25.3% ROR.

David